Is Bank Competition a Threat to Financial Stability?

The global financial crisis reignited the interest of policymakers and academics in assessing the impact of bank competition on stability and rethinking the role of the state in shaping competition policies. Competition in the financial sector has a long list of obvious benefits: greater efficiency in the production of financial services, higher quality financial products and more innovation. When financial systems become more open and contestable, generally this results in greater product differentiation, a lowering of the cost of financial intermediation and more access to financial services. But when we turn to the issue of financial stability, it is no longer so obvious whether competition is beneficial or not, with a continuing debate among academics and policymakers alike. Some believe that increasing financial innovation and competition in certain markets like sub-prime lending contributed to the recent financial turmoil. Others worry that as a result of the crisis and the actions of governments in support of the largest banks, concentration in banking increased, reducing the competitiveness of the sector and potentially contributing to future instability as a result of moral hazard problems associated with “too big to fail” institutions.

In parallel, the financial crisis also led to a re-examination of risk assessment practices and regulation of the financial system, with a renewed interest in systemic fragility and macro-prudential regulation. This requires a focus not on the risk of individual financial institutions, but on an individual bank’s contribution to the risk of the financial system as a whole. Hence, there is a growing consensus that from a regulatory perspective of ensuring systemic stability, the correlation in the risk taking behavior of banks is much more relevant than the absolute level of risk taking in any individual institution.

In a recent paper my co-authors Deniz Anginer, Min Zhu and I investigate the relationship between bank competition and systemic stability, using a sample of 1872 publicly traded banks in 63 countries from 1997 to 2009. Unlike most of the previous literature using bank level data to investigate the link between competition and bank fragility, we do not look at individual bank risk, but the co-dependence of those risks, hence systemic risk. In other words, we examine the correlation in the risk taking behavior of banks, measured as the total variation of changes in default risk of a given bank explained by changes in default risk of all other banks in a given country.

As explained in an earlier post, we follow Anginer and Demirguc-Kunt (2011) and use Merton’s (1974) contingent claim pricing framework to measure bank default risk and its contribution to systemic risk. We use as our main measure of lack of competition the Lerner index, which is a proxy for profits that accrue to a bank as a result of its pricing power in the market. (As a robustness check, we also use bank asset concentration as an alternative proxy, which is measured at the country level.) A cursory look at the time series trends in average systemic risk and bank market power indicates a positive relationship, which we examine further below.

Figure 1: Time series change in the Lerner indexThis figure shows the evolution of the Lerner index over time.

Figure 2: Time series change in R-squaredThis figure shows the evolution of R-squared from a regression of a bank’s weekly change in distance to default on country average weekly change in distance to default (excluding the bank itself).

Next, we examine the relationship between these variables controlling for a number of bank level variables such as bank size, leverage, market-to-book ratio, loan loss provisions, reliance on deposits for funding, and profitability. We also control for GDP per capita to measure the economic development of a country, the variance of GDP growth rate to measure economic stability, population to measure country size, imports plus exports of goods and services divided by GDP to measure global integration, stock market capitalization divided by GDP and private credit divided by GDP to control for differences in financial development and structure, and the years in which a country experienced a banking crisis. As our co-dependence measure may be mechanically linked to the number of cross-sectional observations, we also control for the number of banks in each country, as well as bank and year fixed effects.

In addition to looking at the link between stability and bank competition, we examine the impact of the institutional and regulatory environment. We consider three groups of bank regulation/institutional variables. The first group of regulatory variables is related to state policies that enable or restrict competition such as entry barriers, denial of applications, and government ownership of banks. The second group of variables measures bank regulation and supervision and safety nets, such as restrictions on activities, guidelines on diversification of assets, supervisory powers, and deposit insurance coverage. Finally, the third group measures the strength of private monitoring and information, such as the quality of investor protection, depth of credit information, and existence of a private information bureau.

What do we find? First of all, there is a robust positive relationship between bank competition and systemic stability. Our results indicate greater competition encourages banks to take on more diversified risks, making the banking system less fragile to shocks.

Second, looking at the impact of the institutional and regulatory environment on systemic stability shows that banking systems are more fragile in countries with weak supervision and private monitoring, with generous deposit insurance and greater government ownership of banks, and public policies that restrict competition. Furthermore, lack of competition has a greater adverse effect on systemic stability in countries with generous safety nets and weak supervision.

Our paper has important policy implications. Unlike most of the earlier literature, our findings suggest that concentration, as well as market power, are associated with greater systemic fragility. Insofar as competition and systemic stability are concerned, we do not observe a trade-off, which emphasizes the importance of ensuring a competitive environment in banking. However, our results also stress the importance of the underlying regulatory and institutional framework.

Overall, our results lend support to the view that fostering the appropriate incentive framework is very important for ensuring systemic stability. These incentives are shaped by the design of entry and exit policies, the existence and generosity of deposit insurance and safety net policies, good prudential regulation, and availability of information. Hence, it is important for the regulatory framework to strike the right balance between curbing excesses while avoiding potential anti-competitive effects. Our results suggest information availability, prudent capital requirements for entry as well as operation, and better credit monitoring are the types of actions that would improve systemic stability without impairing competition. In contrast, increases in regulatory costs that raise domestic and foreign entry barriers into the financial sector make markets less contestable, depriving countries of many of the benefits of an efficient and innovative banking system, as well as leading to greater fragility.